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Sec. 754 and Ground Leases

By Andrew Pitt, CPA, New York City

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Editor: Alan Wong, CPA

Partners
& Partnerships

A partnership making an
optional Sec. 754 basis adjustment for land subject
to a long-term ground lease is permitted to adjust
the basis of the land but may not allocate the basis
adjustment to buildings or other depreciable assets
the lessee constructed. A partnership is also not
allowed to make an allocation to the leasehold
interest to claim an amortization deduction for an
accelerated tax benefit.

For estate and gift
tax purposes, Regs. Sec. 20.2031-1(b) states that
the value of every item of property includible in a
decedent’s gross estate under Secs. 2031 through
2044 is its fair market value at the time of the
decedent’s death unless an alternate valuation
method is elected.

To determine the fair
market value of land subject to a long-term ground
lease held by a partnership, an appraiser would
consider three recognized methods of valuation: (1)
the cost approach; (2) the sales-comparison
approach; and (3) the capitalization-of-income
approach. The type of property being appraised
dictates the method used. The
capitalization-of-income approach is the method most
frequently used when valuing land subject to a
long-term ground lease. The capitalization-of-income
approach uses an income projection and converts it
into a value by using a discounted-cash-flow
technique.

In Friend,40 B.T.A. 768
(1939), a taxpayer’s estate received rental income
from properties subject to long-term ground leases.
The estate claimed it could deduct from the gross
rentals amortization of the capitalized values of
the rents to be received under the leases. The estate
contended that the properties were separate
assets, one being the leasehold estate with a much
higher value than the other, the reversionary
estate.

The court’s opinion stated that

We are not dealing
here with the case of a taxpayer who has acquired by
purchase or by inheritance a right to receive a
periodic sum of money for a term of years. Clearly
if a taxpayer had invested money in acquiring such
right he would be entitled to deduct from the rents
received each year an aliquot part of the cost of
his investment; for he would be entitled under the
statute to recover back the cost of his investment
without being taxed thereon. [Friend, 40 B.T.A.
at 771]

The Friend court
noted that, as in Codman v.
Miles, 28 F.2d 823 (4th Cir. 1928), cert. denied, 278
U.S. 654 (1929), the courts have held repeatedly
that the mere right to receive income is not subject
to exhaustion even though the right is limited to a
term of years.

The contention that
the value of the estate was each year depleted by
exhaustion is intriguing rather than logical. What
the plaintiff received and was entitled to receive
was not the corpus of the property but the increment
annually accruing therefrom. It is nowhere suggested
that the corpus of the property, from which the
income was derived, was in any way depleted. [Friend, 40 B.T.A.
at 772, quoting Codman v.
Miles]

The opinion further cited Farmer, 1 B.T.A.
711 (1925), where a taxpayer was depreciating land
against rental income he was receiving for oil and
gas exploration. The taxpayer contended that he
should be allowed to allocate his purchase cost
between the value of the land and the value of his
privilege to lease the land for oil and gas
exploration and that the leases constituted a
severance and conveyance. The Board of Tax Appeals
determined that “[a] fee simple title is the highest
estate in land contemplated by the law. In such a
title all lesser estates, right, titles, and
interests merge. When all such interests so merge
there is a complete solidification of title and the
various interests going to constitute that title
lose their identity and are no longer
distinguishable” (Farmer, 1 B.T.A.
at 713). The Board of Appeals agreed with the
commissioner and disallowed the deduction.

The court cases mentioned above do not cite the
current Sec. 167 or Regs. Sec. 1.197-2 (discussed
below) because the cases predate those provisions,
but the law in effect at the time of each of these
cases provided for a depreciation deduction that
mirrors the general rule of Sec. 167(a). The earlier
laws did not, however, provide special rules for
property subject to leases, as does Sec. 167(c)(2),
and did not address leases, as does Regs. Sec.
1.197-2.

Application of the current Code and
regulations leads to the same conclusion that the
courts reached many years ago. Sec. 167(c)(2) states
that if any property is acquired subject to a lease,
no portion of the adjusted basis shall be allocated
to the leasehold interest, and the entire adjusted
basis shall be taken into account in determining the
depreciation deduction (if any) with respect to the
property subject to the lease. Regs. Secs.
1.197-2(c)(3) and 1.197-2(c)(8) state that an
interest in land, including a fee interest, or an
interest as a lessor or lessee is not a Sec. 197
intangible and is therefore not amortizable.
Therefore, if a taxpayer steps up the basis in land
subject to a ground lease, the entire step-up would
have to be allocated to the land under current
law.

While the law discussed here is not new,
the issue is still relevant since long-term ground
leases are common in the real estate industry. The
accelerated tax benefit from the amortization of a
leasehold estate would be a valuable tax shield, but
the courts have denied the deduction numerous times
(although not in recent cases), and the statute and
regulation adopt that interpretation.

EditorNotes

Alan Wong is a senior manager–tax with Baker
Tilly Virchow Krause LLP, in New York City.

For additional information about these items,
contact Mr. Wong at 212-792-4986, ext. 986, or awong@bakertilly.com.

Unless otherwise
noted, contributors are members of or associated
with Baker Tilly Virchow Krause LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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